The Private-Capital Survival Guide

Even with both the economy and the stock market sputtering, private-capital deals are more appealing than ever. Why? Because well-heeled investors still need a place to stow their cash. But it's not just about the money.

Not every Enron story ends unhappily. Late in 2001, publicly held steel-processor Hunt Co. filed for Chapter 11 bankruptcy-court protection. Most of Hunt's work involved bending steel for Enron's gas pipelines (hence the need for Chapter 11), but hidden deep within the company was a 100-person operation that turned out metal tanks used in small-scale mechanical air pumps -- the kind that inflate tires, toys, mattresses, and the like. The unit's managers, well aware that prior to Enron's collapse their business generated $23 million in revenue and commanded 70% of the U.S. market for such tanks, wanted to buy the operation from Hunt and relaunch it as a freestanding private company. But they needed help to swing the deal. Ultimately, the managers tapped their savings to put up one-third of the purchase price; a venture-capital firm put up one-third, and a local engine-rebuilding business, Springfield ReManufacturing Corp. (SRC), put up the remaining third. By June 2002, the pumpmaker, newly renamed Quest Manufacturing Co., was up and running in Strafford, Mo.

Getting out from under the shadow of bankruptcy court was a big step for Quest, but its troubles were hardly over. The company needs at least $5 million in annual revenue to make a go of it, and sales for its first six months were a disappointing $600,000. At that perilous moment, one of Quest's backers, SRC, stepped forward to demonstrate that money is just one form of capital, and not always the most valuable one. SRC president Jack Stack knew that another company in SRC's investment portfolio, a packaging company called Newstream, was looking for a metal-bending outfit that could weld some steel brackets. Stack arranged the introductions, Newstream got its brackets welded, and Quest booked some much-needed revenue. More to the point, a relationship was formed that could pay off for years to come. And it wouldn't have happened without the network of business contacts that SRC brought to the deal along with its checkbook.

Such networks can be almost as useful as money to a new enterprise struggling to gain forward momentum. Angel investors and other private capitalists can put entrepreneurs in touch with potential customers and suppliers and refer them to lawyers and accountants. They can offer counsel based on years of experience with early-stage businesses. They can be there with advice, patience, and a well-thumbed Rolodex at that delicate moment when a business makes the transition from adrenaline-fueled improvisation to professionally managed enterprise.

Of course, these investors expect something in return for their money and contacts. They expect a lot, actually. But it may come as some consolation to entrepreneurs that expected returns have, well, returned to normal levels, after a long, crazy stretch during which investors confidently assumed they would earn 35% on their money, almost double the historical average. Even at half their boom-era highs, current returns, at 20% or so, look pretty good compared with 10-year Treasury-note yields of 4.1% and stock-market returns that can't be printed in a family publication -- good enough to make private capital the investing game of choice for many well-heeled investors. "There's a revolution in private equity today," says Stack. "Even after the stock-market meltdown, a lot of people have cash, and they can't get much for it in the stock market or the bond market. Barring a wild card -- a revolution in South America or a bomb in Baghdad -- private-capital deals will be very attractive to investors for the next 24 months or so."

"There's a revolution in private equity today. Even after the stock-market meltdown, a lot of people have cash, and they can't get much for it in the stock market or the bond market."

That's welcome news for growing businesses, which often find that private capital is their best -- and sometimes their only -- financing option. Such businesses may be too small and risky to attract the notice of banks or the public-equity markets, or like Quest Manufacturing, they may need an infusion of operating capital before they can generate sufficient cash flow to secure a bank loan. That leaves them to negotiate with sources of private capital, which usually buy equity in an enterprise at a price calculated to return 20% to 40%, annualized, in five to seven years (the average private-equity returns noted above are net of all losses and fees). Such returns sound exorbitant, concedes Jeffrey E. Sohl, director of the Center for Venture Research at the University of New Hampshire, until you consider that loss rates for early-stage investors average about 80%.

Maybe so, but giving up a piece of ownership is a significant step for entrepreneurs. That's why they should take care in choosing their financial partners. The value of a private-capital infusion can be multiplied by a financier's vibrant business network and well-developed business imagination. Sometimes the added value comes in the form of financial security and management independence. The sidebar on page 103, "Cashed Out, but Still the Boss," discusses how private capital has enabled many entrepreneurs to liquidate some of the equity they've amassed without giving up operating control.

Such win-win outcomes have lured both institutions and individuals into the private-capital market, making for a high degree of liquidity. According to the University of New Hampshire's Sohl, angel investors and other informal investing groups poured an additional $30 billion into growing businesses in 2001 and at least that much again in 2002. Only about 5% of that money is start-up funding, Sohl says, with the rest going to meet the capital needs of going concerns.

Larger, more formal investing partnerships, which invest in later-stage enterprises, also have money to put to work. Thomson Financial Venture Economics reports that private-equity investors put a total of $13 billion into later-stage deals in 2001, up from $4 billion in 1997, the last year before the outbreak of Internet madness, when private investment surged, touching $16 billion in 1999 and $26 billion in 2000. (Generally speaking, later-stage financing flows to established companies with revenue of $10 million or more that are well managed, consistently profitable, and generate positive cash flow.) So great was the flood of money into new-venture financing during the gold-rush years that much of it is still waiting to be invested, says Thomas S. Shattan, whose Shattan Group, based in New York City, matches entrepreneurs with financiers. "Pension funds and other organizations," he says, "have given so much to private-equity funds over the years to invest in companies that much of it is still there." That's one reason more growing enterprises than ever have been able to arrange financing. Venture Economics reports that 1,172 companies received an average of $11.4 million in later-stage private-equity funding in 2001. In 1997, by comparison, 849 companies received an average of $4.7 million.

Angel investors, private-equity partnerships, and venture-capital firms may have a lot of cash available, but they are in no hurry to part with it. Investors in growing enterprises have repented of their boom-era zeal and incautiousness, and are now subjecting every deal to microscopic scrutiny. "In 1998 and '99," says Joseph Beninati, chairman and CEO of Greenwich Technology Partners, an information-technology consultancy, "institutions were throwing silly sums of money at new ventures. Today, $2 billion funds spend six months agonizing over $5 million investments." Even if an entrepreneur manages to locate investors willing to commit their funds, those investors may not be as knowledgeable, well connected, and energetic as Stack and SRC. "The smart money is not always as smart as you think it is," says a jaded veteran of three start-ups.

Even taking into account those qualifications, cautions, and caveats, however, private capital represents a vital resource for growing companies. It's not the first big financial step in the entrepreneurial life cycle. That first step, seed capital, comes from friends, family, savings, and credit cards and finances the earliest stages of an enterprise -- the development of a prototype, say, or the rental of a storefront and equipment, or simply a market-and-feasibility study to determine whether further investment is worthwhile. Angel investors -- individuals with money to spare and a taste for action -- are the next link in the chain, when a business needs $250,000 to $750,000 in start-up capital. It's in the third stage of growth, when a business's capital needs are greater than most individuals can or will bear alone, that venture-capital firms and private-equity partnerships usually come on the scene. (They don't come on the scene fast enough to suit everyone. For more on one attempt to close the "structural capital gap," see "Closing the Capital Gap" below.) Private-equity partnerships, which often include both institutions and wealthy individuals, are formed to invest in growing enterprises for a fixed period of time. These partnerships often invest alongside venture capital. But private equity tends to be more patient than venture capital, investing in five- to seven-year blocks, compared with the three- to five-year life span of most venture-capital partnerships.

In practice, there is considerable overlap and interplay among angel investors, private equity, and venture capital; the boundaries between angel investors and venture-capital investors are particularly fluid, having mainly to do with their degree of organization and the size of their investments. For the purposes of this article, the term "private capital" will be used broadly to refer to individuals and institutions that operate outside established securities exchanges to provide equity capital to small and midsize businesses in their early stages of growth. For most of these businesses, the key to tapping this capital is in understanding who these financiers are, what drives them, how to find them, and, most important, how growing enterprises can win their backing.

"In 1998 and '99, institutions were throwing silly sums of money at new ventures. Today $2 billion funds spend six months agonizing over $5 million investments."

Most angels, of course, invest money as well as passion, but in his willingness to work with no assurance of financial reward and his eagerness to share what he had learned over a lifetime in business, Hudson is typical of many angel investors. "They experience the entrepreneurial life vicariously," says Inatome. "They want to have an impact, but at their stage of life, they lack that entrepreneurial energy and conviction." Angels on the other side of the country share that involved-but-not-immersed attitude, says Hans Severiens, managing director of the Band of Angels, a group of investors who fund Silicon Valley technology start-ups. "I love to see new things," he says, "and be part of bringing them into the world. But it's not my full-time job." Severiens and Inatome, along with other veterans of the private-capital game, expect many well-off baby boomers to join the ranks of the angels as their careers wind down. "A lot of people at that stage in their lives don't want to lose their edge," says Inatome. "Angel investing is a way to keep their edge sharp without taking too much of their time."

What angels have to offer is what Inatome calls "career capital" -- contacts, resources, judgment. Such capital can be as helpful to a growing business as money, and experienced entrepreneurs stress the importance of lining up career capital even before beginning the search for real capital. "I was unbelievably conscious about seeking out relationships in the early going,"says Greenwich Technology Partners CEO Beninati. "I asked people to make introductions. For example, a board member introduced me to senior managers of Bear Stearns," which to this day uses GTP to help keep its IT infrastructure humming. Inatome, for his part, urges entrepreneurs to form business relationships "where money is not the initial goal. Well before you need money, recruit people whose reputation, values, and success you admire. Your relationships with them will make it a lot easier to raise money when the time comes."

Perfect Pitch and Other Money-Raising Secrets

How does an entrepreneur, immersed in the infinite details of building a business, form vital business relationships in the first place? A good place to start is the directory of private- and angel-capital firms and networks that appears on page 106. But that's only the beginning. SRC's Stack points out that local bankers are a font of knowledge about the local business and financial scene. Even if they don't have money to lend -- most early-stage businesses don't have sufficient assets or revenue to secure a bank loan -- they know who the local players are because banks are often invited to participate in private-capital partnerships. Another good place to start is the local chamber of commerce. Most chambers maintain close ties with local angels and private-capital firms and can often help match entrepreneurs with like-minded backers. Entrepreneurs should also consult local or regional business journals, many of which compile annual lists of business resources in the area, including law firms, insurers, professional-services firms, and private-capital outfits. People who are contemplating leaving the corporate world to start their own business have a particularly valuable resource: former colleagues who have already made the leap. They can help steer newbies away from avoidable errors and help sift the ranks of professional investors to find the best combination of money and what Inatome calls "nonfinancial currency."

Once introductions are made and relationships formed, the same sort of forethought should go into the process of actually raising money. Veteran entrepreneurs and investors agree that the time for a business to raise money is long before it's needed. "Start early," counsels Inatome. "Don't make your first contact when you're desperate -- it's intuitively distasteful to have someone ask you for money when they're desperate." But desperation is more than a lapse of taste, as SRC's Stack points out. It can also be a fatal strategic error. The more urgent an entrepreneur's need for money, the more onerous are the terms a financier can extract in exchange. "I've seen companies tie themselves in knots because they needed money badly," says Stack. "They'll sell 20% of their equity to someone and promise that the stake will never be diluted. Conditions like that can stop a company's growth cold."

Appeals for early-stage financing usually take the form of a presentation to a group of potential investors. Such presentations are crucial moments in the life of a nascent business, and they're worth every bit of energy expended in preparing and delivering them. It's hard to overstate the power of a good presentation. Potential investors remember pitches that anticipate and address their needs and concerns, if only because they are relatively rare. For example, it should go without saying that every presentation should include the idea for the business and a detailed plan for executing it. Yet every angel or private capitalist we spoke to for this article could recall instances of entrepreneurs looking for backing for an idea before they had any clue how they might profit from it.

Presentations should also be delivered in language the audience can understand. Severiens, of Silicon Valley's Band of Angels, complains about engineering types who forget that not everyone is as fluent in technical jargon as they are. "When they're developing their prototype," he says, "these guys spend 25 hours a day underground with other engineers, speaking a kind of shorthand. Then they come up to the surface to make their presentation, and they start talking the way they talk to their buddies, and I swear, you have no idea what they're saying."

As important as the idea and the business plan are, the real product entrepreneurs have to sell, especially in the early stages, is themselves. "First-stage investors are evaluating the jockey, not the horse," says Greenwich Technology's Beninati. "They need to see you're a capable person, and they need to see your work ethic. They need to be sure you're going to devote the intensity and the time to getting those first few victories." They also need to see that the entrepreneur is the sort of person who can be trusted with other people's money. That means being scrupulously honest about even the smallest details. This too should go without saying, but in their eagerness to turn their business dreams into reality, even the most ardent devotees of the truth might be tempted to round off the corners of a few sharp-edged facts or omit a piece of unfavorable data. This temptation, though understandable, must be resisted, counsels SRC's Stack. "One lie, and it's over," he warns. "One bluff, and it's over."

Even well-put-together presentations can founder, however, because of a failure to appreciate a crucial difference between entrepreneurs and investors: Entrepreneurs focus on the potential of an idea; investors focus on its risks. "The key to raising capital is lowering risk, not hyping the upside," says Douglass Tatum, CEO of Tatum CFO Partners and an authority on small-business financing. "The entrepreneurs who say how they'll reduce risk are the ones who get the capital." Of course, investors in growing companies understand that risk is part of the equation, but they want to see evidence that an entrepreneur recognizes the risk factors facing the business and has taken steps to control them. That means devoting a considerable amount of presentation time to addressing questions about market risk, financial risk, and technological risk. Remember, suggests Frank Gwynn, president of Freedom Medical, private capitalists "aren't entrepreneurs, they're numbers people -- they look at risk versus return." And that is how entrepreneurs should frame their business propositions when they make their presentations -- stressing not the dazzling upside but the return investors can reasonably expect, weighed against a limited and carefully defined set of risks.

"The key to raising capital is lowering risk, not hyping the upside. The entrepreneurs who say how they'll reduce risk are the ones who get the capital."

The most effective way to confront investors' concerns about risk, says Tatum, is to spell out exactly how the business will use the capital and how the capital will enable the business to increase profits, or at least become profitable. It's not enough, he says, to claim that the additional capital is needed for growth, since growth itself is a risk factor. He tells the story of a sandwich-shop franchisee with three stores who was seeking financing to expand to seven stores. Expansion to seven stores required the entrepreneur to add a layer of overhead -- a formal human-resources department, line management -- that absorbed more working capital than the additional stores could generate in revenue. So the sandwich-shop owner instead expanded to 13 stores, Tatum says, giving the business sufficient scale to offset the additional overhead. Had the entrepreneur expanded only to seven stores, he would have merely grown into unprofitability -- perverse as that may sound. "When you bust out of being small," Tatum says, "that's when the problems start."

Capital Connections: How Business Problems Get Solved

of course, even promising business ideas have their share of flaws and worry points. Presentations can be helpful to experienced private investors precisely because they reveal weaknesses and blind spots -- in either the business plan or the entrepreneur -- that can be addressed through the investors' network of contacts. Consider one of Rick Inatome's recent deals. The onetime beneficiary of angel capital is now something of an angel himself, and he recently traveled in Europe in search of promising opportunities. One entrepreneur presented an energy-saving technology that he wanted to market to operators of indoor ski parks, which are a popular recreation option in Europe and Japan. Energy costs are, no surprise, the biggest item in a park operator's budget, and the entrepreneur's innovation promises to reduce those costs up to 40%. After hearing the entrepreneur's presentation, Inatome decided to invest, even though the presentation made it plain that the entrepreneur "had no idea how to look at international partnerships." Drawing on relationships developed over the course of his career, Inatome was able to connect the entrepreneur with experts in master licensing agreements -- a necessity, since ski-park operators would license the energy-saving technology from the entrepreneur's firm -- and other specialists who could, in Inatome's words, "add value to the business plan."

That value can take many forms. When he's recruiting managers for SRC's investment partnerships, Stack looks for "someone who knows how to use resources." By that, he means someone who is familiar with the business's problems as well as with people who can solve those problems -- a retired manufacturing executive who can help clear a production bottleneck, say, or an adoption lawyer who can help a valuable employee with foreign-government paperwork. Here again, banks constitute an underutilized resource. "You should expect business expertise from commercial lenders," Stack says. "A lot of people don't ask bankers to do enough -- it's the intimidation factor." Banks constantly monitor the local economy, running projections and constructing best- and worst-case scenarios. Most banks will share that information with their business customers -- even those that just maintain a small payroll or operation account. The data can sharpen forecasts and improve risk analysis.

When the Financial Dating Game Begins Again

As a business matures and expands, its financing needs change, as does the value that the right financial partner can add. Freedom Medical, based in Exton, Pa., rents and repairs medical equipment such as ventilators, monitors, and infusion pumps -- an attractive financing option for hospitals facing capital-budget constraints because lease costs are charged to operating budgets. The company recently tapped the private-capital market to raise $30 million to fund its national expansion. Freedom is well past the start-up phase and is already professionally managed, says founder and president Frank Gwynn, so it no longer looks for management advice from its financiers. Instead, when Freedom hired an investment bank to place its equity with institutional investors, it looked for a firm that had experience with midsize companies, had a network of potential investors, and was interested in an ongoing relationship. "We were looking," says Gwynn, "not just for cash but for a strategic partner."

After what Gywnn calls a "dating game," Freedom decided Minneapolis-based RBC Dain Rauscher most closely fit its search criteria, and the investment bank then huddled with Freedom's finance and accounting staff to produce the all-important "book," the compendium of financial data and projections that is distributed to potential investors. Dain Rauscher then pitched the deal to 30 private-capital partnerships, selecting them from its network of investors based on their appetite for health-care investments and their long-term orientation. The investment bank further cemented the relationship by taking a piece of the deal for itself. Gwynn attributes the success to "a lot of forethought. Selecting who's going to do the capital raising -- it's quite a process to do it right." Freedom took eight months to settle on an investment banker, structure the offering, and close the deal, and the process could easily have taken longer.

Indeed, experienced entrepreneurs and financiers say that the time to start thinking about later-stage financing is during a business's earliest stages. Most small businesses, says Stack, go through "three or four circles of hell" as they grow. As a business moves from one circle to the next, its financing needs increase by several orders of magnitude. Those needs are met only by diluting the equity held by current investors. Satisfying a business's financing requirements while placating investors dismayed at the shrinking of their ownership stake is "a brutal, energy-sapping business," says Stack. He advises working backward from the moment in the future that a business goes public or places a large block of private equity with institutional holders. "You've got to be realistic in your business plan," he advises, "and prepare your early-stage investors for the prospect of dilution." Freedom Medical's Gwynn suggests one way to frame the issue for those early investors: "Would you rather have 100% of $20 million or 50% of $500 million?"

That's a question many entrepreneurs would love to have to ask. Reaching that stage, says financing expert Tatum, "takes a series of small miracles." One of those miracles, surely, is finding a source of capital that can bring more than money to the table. And though this guide may be helpful, we can't guarantee that everyone who reads it will find the financier or venture of his or her dreams. But if we can make those small miracles a little more a matter of planning, and a little less a matter of dumb luck, well, it's a start.

Harris Collingwood is a business writer based in Cambridge, Mass. This is his first article for Inc. Additional reporting by Thea Singer

Cashed Out, But Still the Boss

In 1995, William Green was the chairman and CEO of $48 million Wilmar Industries Inc., a wholesale supplier of repair and maintenance products to apartment-building owners. Then 37, he was the sole owner of the business, having bought out his father and cofounder in 1990, and was supporting his wife and three young children on a salary of about $130,000 a year. Wilmar, based in Moorestown, N.J., was consistently profitable, boasting gross margins of around 40%, but nearly all the profits were plowed back into the business. "All my net worth was in the company," Green says.

Green credits private capital with making him a better, more decisive manager: "The minute you have real smart people buy in, you pull the trigger faster."

It was time to take some chips off the table. After briefly considering taking Wilmar public, Green turned to the private-capital market instead. He entertained pitches from half-a-dozen private-equity firms, ultimately opting to cut a deal with Boston-based Summit Partners, which paid him $22 million for 55% of the company. Summit's winning edge: Its principals assured Green that they wanted him to continue to run the company. "Quite frankly," Green says, "they wouldn't know the difference between a light bulb and a toilet seat. They wanted a company that had growth opportunity and great management. Why fool with the chef when the restaurant customer is real happy?"

Private capital is becoming an increasingly popular route for those entrepreneurs who want to harvest some of the equity they have built up in their business without giving up operating control -- and without taking on the reporting, regulatory, and administrative burdens that accompany public ownership. A big pile of cash, though awfully nice, is not the only benefit of the transaction, entrepreneurs say. Green credits private capital with making him a better, more decisive manager. "When you're alone," he says, "at least if you're a conservative businessperson like me, you don't want to make mistakes. But the minute that you have some real smart people who do this for a living buy in, you pull the trigger faster."

While the private-capital market has long been the market of choice for entrepreneurs who are looking to play out their exit strategies, it can come on the scene well before the last act, enabling business owners to realize liquidity without relinquishing control of their enterprises. For many entrepreneurs, raising private capital is as close as they'll ever get to having their cake and eating it too.

Thea Singer

Closing the Capital Gap

Think of it as a Bermuda Triangle for growing companies. The good ship Enterprise is sailing smoothly along, volume is expanding, the business is ready to step up to the next level, and...the tiny ship sails into a fog bank, never to be seen or heard from again.

What is this strange zone that growing companies seem almost compelled to enter, but from which so few emerge? Call it the capital gap, an in-between place occupied by companies that are, in the words of small-business financing expert Douglass M. Tatum, "too big to be small and too small to be big." Jeffrey E. Sohl, director of the Center for Venture Research at the University of New Hampshire in Durham, has found that companies typically enter that zone somewhere between $100,000 and $2 million in revenue. When they require additional capital to expand, add employees, or take on more inventory, business owners suddenly find their needs too great for angel investors to afford, yet too small to attract the notice of banks, venture capitalists, or private-equity partnerships.

Banks find it difficult to make a loan pay when the borrower isn't very larg